In which situation should you exercise an American call or an American put early, assuming no...

In which situation should you exercise an American call or an American put early, assuming no dividends? Provide your reasoning.

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Expert Solution

An American option is different from a European option( which is followed in India) in terms of exercising the option. American Option can be exercised on or before the expiry date whereas a European option can be exercised only on the expiry date.

It is not suggested to exercise an American option of a non dividend paying stock. As exercising an option is relevant only in case of In The Money(ITM) options, we are considering only ITM options for the explanation.

Reasons:

An option price is determined by intrinsic value and time value. If an option is exercised before expiry, we are sacrificing the benefit of time value of the option(extra amount that will be obtained as premium due to the time value). Hence it is better off with selling the option (selling an option factor in the time value as well) rather than exercising it if the stock has no dividend payout.
The cash that we have to pay during exercising an option has a time value, so it is better to exercise and buy the options at strike price on expiry since we can delay the payment and use this cash to earn interest from the bank till the day of expiry.

jeff jeffy answered 1 year ago

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